Barriers to investment in the informal venture capital sector - UZH

ENTREPRENEURSHIP & REGIONAL DEVELOPMENT, 14 (2002) , 271 ± 287

Barriers to investment in the informal venture capital sector1 COLIN M. MASON* Hunter Centre for Entrepreneurship, University of Strathclyde, Level 14, Livingstone Tower, Richmond Street, Glasgow G1 1XH, Scotland; e-mail: [email protected]

RICHARD T. HARRISON Dixons Chair of Entrepreneurship and Innovation, Centre for Entrepreneurship Research, Management School, University of Edinburgh , 7 Bristo Square, Edinburgh EH8 9AL, Scotland; e-mail: Richard.Harrison@ ed.ac.uk Much of the government intervention into the market ` gap’ for start-up and early-stage equity ® nance in the UK is based on the belief that the problem is on the supply side. Based on an analysis of the informal venture capital market this paper argues that there is no shortage of ® nance available. A survey of business angels reveals that many are willing to allocate a higher proportion of their investment portfolio to investments in unquoted companies, with recent tax incentives having a positive eÚ ect on their willingness to invest. Over 90% are currently looking to make more investments. However, there are constraints on their ability to invest: they do not see enough deals that meet their investment criteria, the majority of the investment proposals that they receive are of poor quality, and they are often unable to negotiate acceptable investment terms and conditions with entrepreneurs. The implication is that there is a need for further interventions by policy-makers to remove these barriers so that more small ® rms can take advantage of the substantial pool of angel ® nance that is available. Keywords: venture capital; business angels; investment potential; investment criteria; small ® rms policy.

1.

Introduction

In recent years there has been much debate in the UK, as well as elsewhere in the European Union and beyond, about the availability of risk capital for businesses at their seed, start-up and early growth stages. The popular view is that there is a lack of what might be termed ` adventure’ capital because most investors are unwilling to invest in new and recently started businesses, especially if they are in technology sectors, because of perceived high risks and low returns. This view underpins the thinking of policy-makers and is re¯ ected in a range of interventions to increase the supply of early-stage capital, such as the Regional Venture Capital Funds initiative (Department of Trade and Industry 1999), and tax incentives and support for business angel networks (services that ` introduce’ entrepreneurs to potential investors) to expand the pool of business angels. However, based just on a consideration of the angel market place ± which represents the biggest single source of ® nance for * Author for correspondence. Entrepreneurshi p and Regional Development ISSN 0898± 5626 print/ISSN 1464± 5114 online # 2002 Taylor & Francis Ltd http://www.tandf.co.uk/journals DOI: 10.1080 /0898562021014201 1

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businesses at their seed, start-up and early-growth stages (Mason and Harrison 2000a) ± the supposition that the cause of the ` equity gap’ is on the supply side is contradicted both by empirical evidence (Mason and Harrison 1994, 1999, Van Osnabrugge and Robinson 2000) and by the views of informed participants in the marketplace. For example, David Grahame, Managing Director of LINC Scotland, a business angel network, has observed that ` there are . . . companies out there saying that they cannot ® nd money, and our angels are saying that they can only place 10% of what they want to invest’ (Nicholson 2000). This paper addresses this debate. It focuses on business angels ± that is, high net worth individuals (mostly self-made) who invest their own money in unlisted businesses. Business angels have become recognized as the main investors in entrepreneurial companies at their seed, start-up and early growth stages. An analysis of business angel networks in the UK in 1999± 2000 indicates that 75% of investments by business angels involved amounts of £100 000 or less, 59% of their investments were at the seed, start-up and early stages, with a further 33% at the expansion stage, and that they make investments across a wide range of industries, including technology ventures that accounted for 45% of the total (Mason 2001). Our starting point is to suggest that there is no shortage of ® nance that is available, or potentially available, from business angels. In the UK it has been estimated that there are between 20 000 and 40 000 business angels who invest between £0.5 bn and £1 bn per annum in around 3000± 6000 businesses (Mason and Harrison 2000a). As noted above, more than half of these investments are in businesses at their seed, startup and early stages of growth. To put this into perspective, venture capital funds invested in 1182 businesses in the year 2000, of which only 409 (35%) were seed, startup or early stage (British Venture Capital Association [BVCA] 2001).2 Moreover, the supply of ® nance from business angels could be signi® cantly expanded. First, most active business angels are unable to invest as frequently as they would wish because of a lack of suitable investment opportunities (Mason and Harrison 1994, 1999, Van Osnabrugge and Robinson 2000). Wetzel (1986, 1987) interprets this as a sign of market ineÝ ciency. Second, tax incentives would prompt active investors to seriously consider allocating more of their investment portfolio to the unquoted companies sector (Mason and Harrison 1999, 2000b). Third, the proportion of the self-made, high net worth population who are active business angels could be substantially increased with appropriate forms of support (Mason and Harrison 1993). For example, in the USA potential investors outnumber actual investors by a ratio of 3:1 (Freear et al. 1994). In short, there is a substantial pool of informal venture capital available for investment; however, it is not being mobilized eÚ ectively. The challenge for policy-makers is therefore to understand the barriers that prevent this capital from being invested, and to design appropriate interventions for their alleviation or removal. Wetzel (1986, 1987) has argued that the inability of business angels to make as many investments as they would like is an information problem that arises from the largely invisible nature of the participants in the informal venture capital market, which impedes the ¯ ow of ® nance from investor to entrepreneur. The eÚ ect is that investors looking for investment opportunities and entrepreneurs seeking investors both experience high search costs. This, in turn, creates a discouragement eÚ ect, analogous to the discouragement eÚ ect in labour markets, amongst both suppliers of and seekers for capital, encouraging them to drop out of the market. However, with public intervention in the market to support the development business angel

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273

networks, which provide channels of communication through which information about opportunities for investment can be transmitted between entrepreneur and investor, this can no longer be regarded as a complete explanation. Over the past 10 years or so signi® cant numbers of business angel networks (BANs) have been formed in the UK and also in various other countries. However, for a signi® cant proportion of UK investors, membership of one or more BAN has had little or no impact on increasing the volume of potentially investable opportunities that they receive (Mason and Harrison 1999). Thus, there is a need to consider a wider range of factors that on the one hand prevent business angels from investing as frequently as they would wish and, on the other hand, prevent more entrepreneurs from accessing the substantial pool of ® nance that business angels have available to invest. The aim of this paper is therefore to take a broader perspective on the barriers that business angels encounter in investing. First, we identify the size of the pool of uncommitted business angel ® nance. Second, we identify the key barriers which impede the ¯ ow of this ® nance to new and early stage ventures. Finally, we summarize some of the implications for the development of public policy.

2.

Methodology

The inherent diÝ culties involved in identifying samples of business angels are well understood . Business angels are an invisible population who are not listed in any directories and there are no public records of their transactions. Most studies therefore, of necessity, are based either on snowball survey techniques or use samples of convenience. Moreover, the strong desire of most business angels for anonymity (Benjamin and Margulis 2000) and the private and sensitive nature of the subject matter (Haar et al. 1988) generally results in low response rates to postal questionnaire surveys and requests for interviews. Thus, any sampling approach has multiple sources of potential bias. However, as the size and characteristics of the population are unknown and probably unknowable (Wetzel 1983), it is not possible to assess the extent of bias in any individual sample. The paper is based on a postal survey of investors registered with the National Business Angels Network (NBAN).3 NBAN was formed in 1999 on the initiative of the Department of Trade and Industry and is built upon a number of pre-existing local and regional business angel networks with the intention of signi® cantly enhancing and increasing the ¯ ow of investment opportunities to investors. Other aspects of its remit are to help raise awareness of the role of business angel ® nance and encourage more investment into growth businesses. NBAN is structured as a federation of independent local/regional and national business angel networks ± termed special associates ± who ` pool’ information on their investment opportunities so that they are available to all investors across the system. This is achieved by means of the following services: (1) a ` BestMatch’ service, a web site containing searchable business opportunities; (2) a monthly Bulletin, listing new business opportunities; and (3) regular presentations by businesses to investors at locally held meetings. NBAN currently (April 2001) has 26 special associates.4 These comprise both commercially-oriented networks run by private sector organizations and also networks run either by, or on behalf of, public sector and other not-for-pro® t organizations engaged in business development or regional development. In addition to Department of Trade and

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Industry (DTI) support, NBAN receives sponsorship from several private sector companies, mostly in the ® nancial sector. Business angels who are registered with networks clearly come under the category of a sample of convenience. The attraction of such investors for researchers is that by joining a business angel network they have shed their cloak of invisibility. Although their names and addresses are not made public, some networks have been willing to distribute questionnaires to their clients on behalf of researchers on the grounds that improved information on the market will enable them to improve their service.5 However, it remains unclear whether business angels who join business angel networks are in any way distinctive. We have argued elsewhere that any risk of bias is greatest if a sample is drawn from a single business angel network (Mason and Harrison 1997). The important characteristic of NBAN’ s investor database is that it includes the clients of a number of business angel networks throughout England and Wales. We anticipate that this will have the eÚ ect of reducing any bias.6 A total of 84 responses were received by the deadline for their return. This represents a 20% response rate. As other commentators have noted (Haar et al. 1988, Benjamin and Margulis 2000), business angels seek to safeguard their privacy and so are likely to be reluctant to respond to questionnaires, even anonymously . In these circumstances, the response rate is quite acceptable, particularly when the length of the questionnair e is taken into account (12 pages, 46 questions).7 The majority of investors registered with NBAN are private individuals ± i.e. business angels ± and others representing business angel syndicates. However, some professional intermediaries (e.g. accountants) , non-® nancial corporations engaged in corporate venturing and venture capital funds are also registered with NBAN. Just under 90% of responses were from business angels. This paper is based only on the responses of business angels (n= 74). Amongst the business angel respondents, 91% were male and 9% were female. This represents a much higher proportion of women than in previous surveys of business angels where the male response was typically 99%. The regional distribution of business angel respondents was weighted towards the south of England (table 1).

Table 1.

Regional distribution of survey respondents.

Region London South East Eastern South West East Midlands West Midlands North West Yorkshire and The Humber North East Wales Scotland Northern Ireland Overseas No information Total

Number of respondents

%

22 8 6 12 3 6 3 4 0 1 1 0 1 (7) 74

32.8 11.9 9.0 17.9 4.5 9.0 4.5 6.0 0 1.5 1.5 0 1.5 100

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3. 3.1

Investmen t potential Income and net worth

Most business angels have a high net worth and signi® cant income. Just under threequarters (71%) of respondents to our survey have a net worth (excluding principal residence) in excess of £500 000, with millionaires comprising 62% of all respondents. In terms of income, 12% had £250 000 or more, 43% were in the £100 000± £249 000 range with a further 39% in the £50 000± £99 000 range. However, whereas wealth is a necessary condition for someone to become a business angel, in most cases it is not suÝ cient. The source of wealth is also signi® cant. Business angels are much more likely to have achieved their wealthy status through their own eÚ orts, as opposed to having inherited it (i.e. ® rst generation money) and, in particular, have achieved their wealth through entrepreneurial activity rather than in a high income occupation.8 This is re¯ ected in this study: 71% of our respondents had founded one or more businesses; on average the respondents had started two businesses and 9% of respondents had founded ® ve or more businesses. Thus, as previous research has suggested, one of the very few sustainable generalizations that can be made about business angels, who in most other respects are a very heterogeneous population, is that they are typically successful cashed-out entrepreneurs.

3.2

Motives for investing

Business angels invest in unlisted companies predominantly for ® nancial reasons (table 2). By far the most important reason is ` the potential for high capital appreciation’ , with current/future income ranked third. However, con® rming previous research, non-® nancial motives emerge as a very strong secondary consideration for becoming a business angel. Indeed, ` personal satisfaction from being involved with entrepreneurial businesses’ is the second most important reason for investing. Another signi® cant non-® nancial reason for investing in unlisted companies is ` a way of having fun with my money’ . For most of these business angels there is no trade-oÚ between Table 2.

Motives for investing. Percentage of respondents

Motive To support the next generation of entrepreneurs Personal satisfaction from being involved with entrepreneurial businesses Potential for high capital appreciation To help a friend/friends set up in business For current or future income, e.g. dividends, fees Support socially bene® cial products or services A way of having fun with some of my money For positive recognition in the community For non-® nancial perks, privileges and bene® ts To make use of tax breaks, e.g. Enterprise Investment Scheme

Very important

Quite important

Not important

9 53

36 36

55 11

72 3 41 5 14 1 1 19

24 10 32 10 46 3 8 41

4 87 27 85 40 96 91 41

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® nancial and non-® nancial motives: it is a both/and rather than an either/or choice. Signi® cant secondary considerations for investing include ` to make use of tax breaks’ and ` the desire to support the next generation of entrepreneurs’ . However, in other respects business angels are not motivated by altruistic concerns, with 85% stating that the support of socially useful products and services is not a reason for investing. As other research has suggested (Barker 1999), most business angels regard their investment activity as totally separate from their philanthropic activities. Finally, most business angels do not invest to receive personal recognition in the community: respondents were almost unanimous in stating that this is not a consideration. Business angel investment is, therefore, primarily an economic phenomenon , undertaken by investors in the expectation of signi® cant returns. However, the secondary importance of a desire for involvement in the entrepreneurial process emphasizes that business angel investors bring more than money to the deal, and seek to contribute their experience and knowledge to their investments. Indeed, 94% of respondents describe themselves as hands-on investors who bring a wide range of experience in terms of functional expertise, length of senior management or professional experience and industry knowledge to their investee businesses.

3.3

Investment activity: actual and potential

Of the 74 business angels who responded, 52 (70%) had made investments in the 3 years prior to the survey. These investors had collectively invested £12.25 million in 118 businesses.9 Assuming that the investor characteristics of the sample are representative, this translates into an estimate of around £60 million invested in over 600 businesses by NBAN investors in the 3 years prior to the survey. For most business angels these investments represented only a relatively small proportion of their investment portfolio, typically between 5 and 10%. The remainder of their portfolio is invested in the stock market (93% of investors), property (62%) and banks/building societies (57%) and, to a lesser extent, bonds (49%) and gilts (36%). Relatively few business angels invest in art/antiques, collectibles or other more esoteric categories (table 3), con® rming that they are ` investment’ rather than ` consumption’ investors. Table 3.

Investment portfolios of business angels.

Asset class Stock market (including unit trusts, investment trusts) Property (other than principal residence) Bank/building society Bonds Gilts Art/antiques Collectibles: e.g. coins/stamps, vintage cars, etc. Fine wines Racehorses Other Investors could give more than one category.

Percentage of respondents investing in this asset class (%) 93 62 57 49 36 31 12 12 4 7

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Table 4. Maximum proportion of portfolio that business angels are willing to invest in unlisted companies. Percentage of portfolio

Percentage of respondents

Less than 5% 5± 9 10± 14 15± 19 20± 24 25± 29 30% and over

2 3 23 3 23 10 36

However, many business angels are prepared to allocate a higher proportion of their investment portfolio to investments in unlisted companies (median= 20%) (table 4). The factors that in¯ uence the proportion of their portfolio that business angels invest in unlisted companies appears to be largely determined by personal rather than environmental considerations. As table 5 shows, the tax regime and, to a lesser extent, economic growth are the only economic factors that have a signi® cant in¯ uence on how most business angels make their investment portfolio allocation decision

Table 5. Role of economic conditions in in¯ uencing the proportion of their investment portfolio that business angels allocate to investments in unlisted companies. Percentage of respondents Discouraging investment Economic condition Rising interest rates Stable/falling interest rates Rising stock market Stable/falling stock market High in¯ ation Low in¯ ation Higher capital gains tax Lower capital gains tax Property prices rising above the rate of in¯ ation Static/falling property prices Increasing economic growth Stable/decreasing economic growth Higher tax on dividends Lower tax on dividends Income tax relief on amounts invested in unquoted companies Continued presence of Alternative Investment Market [AIM] Absence of Alternative Investment Market [AIM]

Encouraging investment

A lot

A little

No in¯uence on investment

A little

A lot

9 0 0 0 7 2 30 2 0

27 3 15 17 14 5 21 3 8

55 61 57 68 65 72 41 43 78

3 18 15 8 9 6 2 26 6

6 18 13 8 5 16 6 26 6

2 2 5 27 0 3

8 0 25 16 5 0

77 36 60 47 52 23

8 36 6 9 20 31

6 26 5 2 23 43

3

0

68

17

12

9

14

74

3

0

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and speci® cally on the proportion of their portfolio that is invested in unlisted businesses. Higher rates of capital gains tax and higher tax on dividend incomes would each discourage half of the respondents from investing in unlisted companies. Conversely, reducing the rate of capital gains tax would encourage 52% of investors to invest more (26% would be encouraged ` a lot’ ) while reducing tax on dividends would encourage 43% of investors to invest more in unlisted companies. A total of 74% of business angels would be encouraged to invest more (43% ` a lot more’ ) by front-end tax reliefs. This emphasis on tax is consistent with the earlier evidence on motives for investing, which noted that making use of tax breaks is an important reason for making investments. Indeed, 38% of the investments made by respondents used the Enterprise Investment Scheme.10 It also suggests that the recent introduction of a capital gains tax taper ± which reduces the rate of capital gains tax for higher rate taxpayers to just 10% after an asset has been held for 2 years ± should have the eÚ ect of increasing the amount of ® nance that business angels are willing to invest in unlisted companies. In contrast, more than half of all respondents are not in¯ uenced by interest rates, stock market trends or the rate of in¯ ation, and less than one-quarter of investors are in¯ uenced by property prices.

3.4

Time constraints

The process of investing involves considerable time: there is a need to identify potential investment opportunities; once identi® ed, the process of assessing, structuring and negotiating the investment can be lengthy; and having invested, most business angels then devote signi® cant amounts of time to supporting their investee businesses. Respondents to this survey work an average of 6 days per month in each of their portfolio companies. Moreover, for most business angels, investing is a part-time activity. Thus, while business angels may have additional capital available, they may not have suÝ cient time to add to their existing portfolio of investments in unquoted companies. Indeed, previous studies have con® rmed that the lack of time to search for and evaluate investment opportunities are signi® cant barriers to investment (Mason and Harrison 1999). In this survey more than one-half (57%) of the respondents con® rmed that there is an upper limit to the number of investments in their portfolio that they are capable of managing eÚ ectively. The average maximum portfolio size is ® ve investments but one in ten investors gave a limit of more than 10 investments. The key constraints are, ® rst, insuÝ cient time to monitor the performance of additional investments (45%) and, second, the time available to play a hands-on role (45%). However, the vast majority of business angels in this survey reported that they have not reached the limit of their investment capacity.

3.5

Summary

This section has established that business angels do have potential untapped capital that is available for investment in unquoted companies. They are willing to allocate a higher proportion of their investment portfolios to such investments and have the time available to search for and manage additional investments. Recent changes to the tax regime ± some of which were announced after the survey was undertaken ± seem likely to reinforce their willingness to increase their investments in unquoted companies.


279

Table 6. Amount that business angels have available for investment. Amount < £25 000 £25 000± 49 000 £50 000± 99 000 £100 000± 249 000 £250 000± 499 000 £500 000± 999 000 > £1 million

Percentage of respondents 7 2 18 43 15 10 4

Indeed, more than 90% of respondents are currently looking to make further investments. The amounts that they have available to invest range from around £10 000 to over £1 million, with an average of £100 000 (table 6) and in aggregate terms is very signi® cant, exceeding the amount that they have collectively invested in the 3 years prior to the survey. Extrapolating from this sample to the population of angel investors registered with NBAN, this suggests that NBAN members have around £70 million available for investment. If business angels are unable to invest this money in unlisted companies it will be redirected predominantly to the Stock Market, banks and building societies and property. The remainder of this paper therefore considers whether business angels encounter barriers to investing in unlisted companies and, if so, what form they take and how they might be overcome.

4.

Barriers to investment

A useful way in which to structure this discussion of potential barriers to investment for business angels is in terms of the three key stages in the investment decision-making process: screening, evaluation and negotiation (Mason and Rogers 1997, Feeney et al. 1999). The ® rst aspect is the business angel’ s investment criteria. The ® rst reaction of business angels when screening an investment opportunity is to consider the extent of the ` ® t’ with their own personal investment criteria (Mason and Rogers 1997). Having established that an opportunity satis® es their personal investment criteria angels then go on to evaluate its intrinsic merits. The ® nal stage in the investment process is the negotiation over the terms and conditions of the investment.

4.1

Investment criteria

Nearly two-thirds (64%) of respondents have clearly de® ned investment criteria which in¯ uence the types of businesses that they will consider investing in. These criteria include stage of business development, industry, technology and location. The business angels in this study are primarily interested in investing in established companies seeking expansion ® nancing, early stage expansion and to a much lesser extent start-up ® nancing. Only a small minority of business angels are interested in investing at the seed stage. A signi® cant proportion are also interested in investing in management buyouts and buy-ins (table 7).

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Table 7.

Investment preferences of business angels: stage of business development. Percentage of respondents No interest

Stage Seed (pre-start-up) ® nancing Start-up ® nancing Early stage expansion ® nancing Expansion ® nancing for established ® rms Rescue ® nancing Management buy-outs Management buy-ins

26 7 1 7 41 21 20

Moderate interest 30 29 7 16 19 11 10

Very strong interest

30 29 21 11 16 22 24

9 17 36 30 13 24 24

6 19 34 36 12 22 22

Most of the survey respondents also impose restrictions on the industries that they will invest in. In response to an open question on industries that they were particularly interested in investing in, or would not consider investing in, positive responses outnumbered negative responses. This challenges the conventional wisdom that business angels are better able to articulate what they would not invest in, rather than what they would consider investing in. The industry preferences were generally articulated in very precise terms rather than in terms of broad industry sectors. Moreover, the preferences were extremely varied. For example, for every investor who stated an interest in investing in traditional manufacturing or engineering businesses there was another who would not consider investing in these sectors. Similarly, some angels are averse to investing in technology sectors whereas others take the opposite view. More than 4 out of 10 investors expressed a strong or very strong interest in internet, IT and telecoms businesses; interest in multimedia and biotechnology was less strong (table 8). These industry preferences re¯ ect the fact that business angels generally invest in sectors, markets or technologies where they have some degree of familiarity or direct experience (Kelly and Hay 1996). More than 6 out of 10 investors say that their ability to invest is limited by their lack of knowledge of particular industries, technologies and markets. Indeed, business angels reject an average of 80% of the investment proposals that they receive for this reason. Over one-half (55%) of all business angels also have a geographical limit beyond which they will not consider investing. For the majority of these investors (67%) the

Table 8.

Interest of business angels in technology sectors. Percentage of respondents

Sector Internet/e-commerce IT (information technology) Biotechnology Telecommunications Multi-media

No interest 20 19 32 16 26

Moderate interest 14 10 20 11 13

20 24 23 31 33

Very strong interest 19 18 11 20 11

27 29 14 22 17

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Table 9.

Situations when business angels are prepared to relax their investment criteria.

Situation

Percentage of respondents

None: never invest outside of investment criteria High credibility of entrepreneur/management team Small investment required Location of business very close to home/workplace Recommendation from trusted source Prospect of very high returns Intuition/gut feeling Availability of co-investor/syndicate Convincing presentation by entrepreneur Referral from a business angel network To diversify my portfolio of business angel investments Opportunity to syndicate with other investors

11 53 31 31 30 27 27 22 20 10 7 5

Respondents could cite more than one category .

limit is 2 hours travelling time. Moreover, very few investors are interested in investing in continental Europe (10%) or North America (4%). However, we know from anecdotal evidence that business angels’ investment preferences are not necessarily a good guide to their actual investments. Indeed, most of the business angels in this study indicated that they will consider relaxing their investment criteria in certain circumstances, notably where the entrepreneur/management team has high credibility (table 9), con® rming other evidence that angels place much greater weight on the ` jockey’ than on the ` horse’ (Fiet 1995a, b, Van Osnabrugge and Robinson 2000, Harrison and Mason 2002). Investors will also be more likely to invest if the referral is recommended by a trusted source (Harrison et al. 1997). Other factors that encourage some investors to relax their investment criteria are the location of the business close to the investor’ s home ± which has the eÚ ect of reducing transaction and monitoring costs ± and a small deal size ± which may encourage a speculative investment.

4.2

Quality of investment opportunities

The quality of deal ¯ ow that business angels see is a further signi® cant barrier to investment. In this survey, 81% of respondents indicated that their ability to invest is limited by the quality of the opportunities that they see. According to the angels themselves, the main de® ciencies in the proposals that they see are business plans which contain unrealistic assumptions or information that is not credible and, second, the entrepreneur/management team lacks credibility. Signi® cant, although less frequently cited, weaknesses include insuÝ cient information provided, business concept requires further development and limited growth prospects of the business (table 10). This is consistent with the few other studies to have examined the investment decisionmaking process of business angels (Mason and Harrison 1996a, Mason and Rogers 1997, Feeney et al. 1999). The deal ¯ ow that business angels receive comes from a variety of formal and informal sources. For this group of investors ± all registered with NBAN ± it is not

282


Table 10. De® ciencies in investment opportunities. Percentage of respondents

Assumptions unrealistic/information lacks credibility Entrepreneur/management team lacks credibility InsuÝ cient information provided Business concept needs further development Growth prospects of business is limited No obvious exit route Lack of originality in product/service Lack of long term vision for business Business under-capitalized/lacks liquidity InsuÝ cient commitment displayed by entrepreneur Lack of integrity of the entrepreneur Other de® ciencies

Found in most (> 75%) of opportunities

Found in many (50%± 75%) of opportunities

43 42 31 24 23 20 20 20 19 12 10 1

27 26 31 24 26 30 22 16 23 22 15 1

Table 11. Sources of information on investment opportunities. Information source NBAN Business associates Other business angel networks Friends Media: magazines, newspapers, etc. Active personal search Accountants Contacted by entrepreneurs seeking ® nance Venture capital funds Lawyers Banks Family Stockbrokers Other sources

Percentage of respondents 66 50 42 40 38 37 32 22 18 16 14 12 12 5

Respondents could give more than one source.

surprising that NBAN is the most common source of information on investment opportunities, with other business angel networks (presumably networks that are local associates of NBAN) also ® guring prominently (table 11). However, the other signi® cant sources of deal ¯ ow are informal ± business associates, friends, media and personal search. By contrast, relatively few business angels obtain information on investment opportunities from formal sources such as accountants, lawyers, venture capital funds, banks, and stockbrokers . This re¯ ects the ad hoc, unscienti® c way in which business angels search for investment opportunities (Wetzel 1981, Mason and Harrison 1994). Informal sources (friends, business associates, other business angels) also attracted the greatest support as the referral sources that provide the best quality of investment opportunities, con® rming earlier US ® ndings (Freear et al. 1992).

283


Table 12. Reasons why terms and conditions of an investment could not be agreed. Reason Could Could Could Could Could Could Could Could Other

Percentage of respondents not agree not agree not agree not agree not agree not agree not agree not agree

on price on shareholding structure on the composition and power of the Board of Directors investor’ s hands-on contribution to the business on exit strategy on remuneration issues on investor’ s right of veto on investor’ s right to information

50 44 18 15 9 6 3 0 21

Based on responses from 34 investors who had failed to agree terms and condition s with an entrepreneur on at least one occasio n in the previous 3 years.

4.3

Failure to negotiate

A ® nal reason why business angels do not invest as frequently as they would like is that they fail to negotiate a deal with the entrepreneur that is acceptable to both sides. This occurs surprisingly often. Indeed, a previous study noted that business angels made four times as many oÚ ers to invest as were accepted (Mason and Harrison 1996b). In this survey 53% of respondents indicated that there had been occasions in the 3 years prior to the survey ± in most cases just one or two ± when they had wanted to invest but had failed to agree on the terms and conditions of the investment. By far the main reasons why the investment was not made was because the angel and entrepreneur could not agree on either the price or the shareholding structure (table 12). This may re¯ ect unrealistic expectations on the part of one or other, or both, parties.

5.

Conclusions

The study underlines the signi® cance of the informal venture capital market as a source of ® nance for unlisted companies. Business angels registered with NBAN have made an estimated 600 + investments involving an investment of some £60 million in the 3 years prior to the survey. As most business angels do not register with business angel networks this scale of investment activity represents just the tip of the iceberg. Furthermore, their investment potential is enormous: business angels registered with NBAN have an estimated £70 million available for investment in unlisted companies and the average business angel is willing to double the proportion of his/her investment portfolio that is currently allocated to unlisted companies. The government can take some of the credit for helping to create this pool of ® nance. Business angels are highly sensitive to the tax regime, and the willingness of active investors to increase the proportion of their investment portfolio that they allocate to investments in unlisted companies can be attributed, in part, to the eÚ ect of tax incentives such as the Enterprise Allowance Scheme and the Capital Gains Tax taper. These initiatives may also be expected to have encouraged other high net worth self-made individuals to become business angels. However, there are signi® cant constraints on the ability of business angels to invest as frequently as they would wish, or as much as they would wish:11

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. business angels do not see enough businesses that meet their investment criteria, and their ability to relax these investment criteria is limited by their reluctance to invest in unfamiliar industries and markets; . the majority of the investment proposals that they see are of poor quality; . to a lesser extent, they fail to negotiate acceptable terms and conditions with entrepreneurs. The clear implication of this study is that the eÚ ectiveness of current government interventions in the informal venture capital market to increase the amount of equity capital that is channelled to new and growing businesses ± involving the provision of tax incentives and contributing to the operating costs of business angel networks ± will be limited because of the existence of various barriers that prevent business angels from investing as often as they would like to. This evidence therefore suggests that the time has come to fundamentally redesign the concept of business angel networks. As originally conceived, business angel networks were based on a diagnosis of information ineÝ ciencies in this capital market. As a result, they have been established to provide a channel of communication between investors and entrepreneurs in order to minimize the cost of the entrepreneur’ s search for capital, and enabling investors to examine investment opportunities that meet their screening criteria, without compromising their anonymity. Business angel networks have been judged to be a success, both in terms of their direct impacts (promotion of investment opportunities, mobilization of capital, investment activity), induced investment eÚ ects (leveraged bank lending), indirect eÚ ects (advice and signposting, feedback) and cost-per-job (Harrison and Mason 1996, but see Blatt and Riding 1996, for a dissenting view). However, conventional BANs will not cause reluctant potential investors to enter the market, nor will they cause the owners of ` lifestyle’ ® rms to attempt to expand their businesses by using external equity capital. Neither are they able to exert much quality control over either their investor or business clients. Furthermore, they withdraw from the process as soon as the introduction is made, and so play no role in the pricing and structuring of any deal, which are signi® cant ` deal breakers’ (Freear et al. 1994). The clear implication is therefore that there is a need to develop ` second generation’ BANs whose role is much wider than simply being an information broker, supplying summary information on investment opportunities to business angels. The focus of such BANs should be on educating the market place.12 Many business angels have fairly narrow investment criteria which they will only relax in certain circumstances. Thus, the probability that a particular opportunity will be of interest to any single angel is fairly low. This underlines the importance of achieving critical mass in terms of investors and investment opportunities. Accordingly, BANs must become much more proactive in their marketing eÚ orts. In addition, they must also seek ways in which they can broaden the investment criteria of investors, for example, by developing educational activities13 and encourage the formation of investor syndicates. The feasibility of providing independent technology due diligence services should also be revisited (Freear et al. 1996, Mason and Harrison 1998). More generally, BANs need to raise the knowledge and competence of both entrepreneurs and business angels and also the small business ` support network’ ± accountants, lawyers, banks, consultants and advisers, etc. ± by developing educational materials and running workshops and seminars. There are three speci® c priorities. First, BANs must seek to educate entrepreneurs on the advantage s of equity ® nancing, in order to convert the need for equity ® nance into demand.14 Second,


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BANs need to ensure businesses are ` investor ready’ when they are promoted to investors and business angels. This involves helping entrepreneurs to understand the expectations and requirements of investors and how to make their business plans into attractive investment opportunities (Mason and Harrison 2001). Previous studies have highlighted problems associated with incomplete information in business plans (Mason and Rogers 1997) and presentational de® ciencies (Mason and Harrison 2000c). Third, bearing in mind that business angels are a heterogeneous population with diÚ ering levels of familiarity with techniques of investing, ranging from successful cashed-out serial entrepreneurs on the one hand to inexperienced and ` virgin’ investors on the other, there is a need for BANs to help the latter group to raise their competence in all aspects of ` doing the deal’ ± how to ® nd, evaluate, price, structure, monitor, add value and exit from venture deals. However, rede® ning the role of BANs in this way raises obvious questions of resourcing. To become more proactive and to engage in a wider range of investor and entrepreneur education will require substantial additional funding and it will not be possible to recoup the additional costs through registration fees and success fees. The rationale for government and other sponsors to provide additional funding, as always, is that ` a thriving informal venture capital market is a pre-requisite for a vigorous enterprise economy’ (Advisory Council on Science and Technonogy [ACOST] 1990: 41). This receives con® rmation in the Global Enterprise Monitor [GEM] 2001 study, which reports that ` the prevalence of informal investors has a statistically signi® cant positive association with the overall level of entrepreneurial activity and a stronger relationship with the level of opportunity entrepreneurship’ . In other words, in countries where the population is investing more personal funds, the level of opportunity-drive n entrepreneurial activity is signi® cantly higher (Reynolds et al. 2001: 22). In examining the role of the informal venture capital market in the funding of ventures at their seed, start-up and early growth stages, it is no longer suÝ cient to de® ne the problem as a lack of available capital: business angels have signi® cant funds available and are prepared to invest more. Nor is it a matter of the mobilization of the capital that is available, which intermediation initiatives such as BANs address, as a signi® cant proportion of investors report receiving poor quality (non-investable) business opportunities being presented to them from this source. Rather, the issue is fundamentally one of competence: many investors lack familiarity with techniques of successful investing, the opportunities which come forward more often than not are not ` investment ready’ , and the bottom level service providers in the small business support network lack the expertise needed to add value to the process. Notes 1. An earlier version of this paper was presented at the 21st Babson College-KauÚ man Foundation Entrepreneurship Research Conference at JoÈ nkoÈ ping International Business School, JoÈ nkoÈ ping, Sweden, June 2001. 2. Moreover, this was an exceptional and wholly untypical year. In 1999, venture capital funds made 260 early-stage investments (23% of the total) and in 1998 made 241 such investments (21%) (BVCA 2001). 3. It should be noted that ` national’ in this context means England and Wales. LINC Scotland, which is not a member of NBAN, provides business angel network services for Scotland. 4. One of these special associates, Equity Link, comprises a network of 12 local BANs in southern England. 5. This study, which was commissioned by the National Business Angel Network, is in this category. 6. It is acknowledged that business angels who are members of a business angel network may not be fully representative of the business angel population as a whole. For example, it can be hypothesized that such business angels may be biased towards those with poorer personal networks (and therefore have a

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7. 8.

9. 10.

11.

12.

13.

14.


more critical need for networking), smaller amounts to invest and remoter locations. However, it is impossible to empirically test for the existence of any biases because of the diÝ culties in identifying business angels (Wetzel 1981, Mason and Harrison 1994). Moreover, previous studies of angels who are members of BANs does not support this stereotype (Mason and Harrison 1999). It was not possible to test for non-response bias because for reasons of con® dentiality we were not provided with any personal information that NBAN holds on its registered investors. In this respect, respondents diÚ er from the recently identi® ed so-called ` mass aÞ uent’ class in the UK ± these are similar in income and net wealth terms, but this has been mostly acquired from employment, notably in the ® nancial services sector, and they have limited exposure to entrepreneurial activity of any sort (also see Anderson 1998). Just under one-quarter (24%) of these investments were identi® ed through information provided by NBAN. This scheme provides private investors making investments in qualifying unquoted companies with income tax relief on the amount invested, any investment gains are exempt from capital gains tax and any losses from the investment can be set against future income tax liabilities and it provides the ability to roll-over tax on capital gains arising from the disposal of other assets (Inland Revenue 2000). In view of the geographically fragmented nature of the informal venture capital market it is quite possible that there are regional variations in the strength of these impediments to investing. However, it has not been possible to explore this issue with the available data. This is a fruitful avenue of enquiry for future research. Lange et al. (2002) highlight an additional pressure on BANs that is prompting such a change in focus. They argue that the impact of the internet is making it harder and harder for BANs to charge for their basic matchmaking services because it has become easier for entrepreneurs to ® nd sources of ® nance without their help. This is putting pressure on BANs to add value to their services. They expect that BANs will respond by evolving from pure intermediation services to become a one stop resourcing service where ® nance is just one piece of a very complex package that also includes team building, management recruitment, advisory boards, directors, etc. A good example is CONNECT, which was initially developed in San Diego but has since been cloned in several other localities around the world, including Scotland and Sweden. Its objective is to support the creation, development and growth of technology-based enterprises. It does this in a variety of ways, including a programme of seminars, brie® ngs, workshops and forums designed to develop the knowledge and expertise of the investment community, advisers and policy-makers. One of the elements in this programme is a ` Technology brie® ng’ . The extent of equity aversion is underlined by the following statistic: four out of every ® ve small ® rms that are referred by banks to LINC Scotland to raise equity ® nance from business angels refuse to go (Grahame, 18 April 2001).

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